8 min read

Reading The Riot Extract

If it be true we are truly in the grip of a "molecule crisis" as Jeff Currie termed it, then Moscow's dilemma lies in how those molecules flow into national accounts and bank balance sheets and fuel economic activity. One of the most frustrating discourses to emerge after the initial annexation of Crimea was that the regime had successfully diversified the economy away from dependence on oil & gas. There were many boosters for this talking point happy to talk on the TASS releases and pedestrian statements on the economy made by Putin various public fora. It was, of course, both a myth and a sleight of hand. While it was true that the country's fiscal dependence on oil & gas revenues declined, the rest of the economy became ever more dependent on the extractive sector because of austerity measures taken to avoid fiscal deficits. BOFIT's visual is the best at capturing just how strong the correlations look like since 2015:

Retail turnover is a direct function of the extractive sector prior to sanctions and export bans. Now that they're in place, the loss of imports detachs this relationship without addressing the underlying problem that investment and output in the extractive sector drive the system of wealth transfers to a greater degree for 2015-2022 than they did after the Global Financial Crisis. What's even more worrying is the degree to which manufacturing is tied up in extractive output, highlighting how dramatically import substitution has failed and stories about rising exports of things like farming equipment tell us more about the relative weakness of domestic demand rather than strength of Russian industrial policy. Revisiting the thesis from the Bank of Russia that the economy was overheating, one might infer that extractive activity in Russia actually exceeded the capacity of what the economy could manage thanks in no small part to the degree to which jobs and production are geographically concentrated in sparsely populated areas and regions that limit economies of scale and potential multiplier effects one finds with large cities. Therefore whenever they have to bid on additional labor or equipment, it has more pronounced effect on inflation once we factor in regional adjustments to salaries for costs of living, the fact that few people want to move to the middle of nowhere, etc.:

Index of Extractive Production, in seasonally adjusted real terms, 2019 = 100 

While the chart from HSE shows an upward recovery from the initial sanctions shock led by rising oil output, coal output is now experiencing a sharp, sudden contraction from the mass disruption to seaborne exports. Miners are also beginning to warn of worsening safety standards, declining efficiency, and falling output as they struggle to find spare parts and equipment they used to import with ease. In recent months, demand for repairmen has risen which isn't a great leading indicator...

Oil is also likely to face a return to significant contraction next year at a time when natural gas output is down by a lot thanks to the cutoffs to Europe:

I'm not going to dive further into the links between extraction, retail, manufacturing, capex levels and so on, but wanted to sketch that quickly for a simple reason: if we're in a molecule crisis because of a variety of market and politically-induced shortfalls of energy supplies, then declines in Russian output can still result in net increases for FX inflows or else increases in the relative size of FX inflows relative to import levels. The following is Bank of Russia data for H1 2022 on the top-level current account figures in USDbn:

The net balance increased slightly in 2Q despite a contraction in exports because of the larger decline in imports. I imagine 3Q will see a decline as imports recover more and crude oil prices have fallen significantly, especially since the massive spike in European natural gas prices won't yield nearly the same benefits for exports to China or LNG purchases at scale now that Gazprom has cutoff supplies:

Calendar Spreads for Brent, Prompt and year-forward basis

The market's signaling weakness ahead for oil, the main moneymaker anyway. So if Russia can't make ready use of its USD and Euros because of financial sanctions and faces import constraints, what exactly can it do with its western FX? Banks are already charging negative interest rates to companies to get them to hold rubles instead (and increase the state's power to direct trade indirectly) and the Ministry of Finance is sorting out its new budget rule and approach to currency sterilization, including the idea floated of purchasing over $70bn in FX from 'friendly' countries, including Yuan:

What I find funny about this situation is that Russia is trying to escape the prison of US dollar hegemony – one of the central targets of elite bromides regarding multipolarity for decades – by engaging in currency swaps with countries bound to the dollar in various ways. Even if the trades are settled, banks and companies are not going to hold rubles to buy Russian exports. China recycles its current account surplus through provisions of US dollar denominated loans across the world and its real estate developers frequently borrow in USD. Turkey, the country most explicitly leveraging its own geopolitical over-extension into FX from Russia, is constrained by the structural limits on its growth tied to currency politics:

Not only is the Ministry of Finance looking to buy "friendly" currencies, it's doing so with a growing budget deficit. These swaps reek of desperation – someone is trying to impress someone else in Moscow and no one has a good plan for what to do with the FX earnings from the West they can't readily mobilize anymore. Let's say this harebrained scheme comes to a head and Moscow starts buying more lira, CNY, riyal or dirham, and so on. They're effectively trying to buy currencies that are pressured by adequate USD/Euro inflows (Turkey) or outflows from high energy prices that Russia has done much to engineer for nat gas/coal (most emerging markets), recycling USD/Euro surpluses while facing risks of financial contagion from real estate assets touching on access to USD liquidity in a decent number of cases (China), or currencies that are pegged to the USD and have much of their geopolitical risk environment shaped by the US (think the GCC).

Not only has Russia's own gamesmanship over energy markets in Europe contributed to the strengthening of the dollar since everyone needs it for imports, but this one idea floated about how to weaken the ruble through bilateral purchases of 'friendly' currencies is largely predicated on Russia's position as a spoke and hub for flows of US dollars and Euros driven by global commodities flows. Complaints about the US dollar in Russia are really arguments about sovereignty and policymakers' general impotence making the ruble and OFZs a safe asset.

There are, of course, other options on the table to weaken the ruble. The Bank of Russia could establish dynamic capital controls, liberalizing them by and large when the ruble is at a certain threshold against the USD and reimposing them at another. They can hold interest rates lower than they have historically to encourage more lending and weaken the ruble by encouraging more inflation (and making industrial investments substituting imports more attractive). While it's ostensibly a measure that strengthens the ruble, abandoning the new budget rule and spending every cent of what's earned from oil exports on investment and fiscal transfers will ultimately have the same effect through inflationary channels. Buying yuan it reportedly can't even convert or move around because Chinese authorities impose considerable capital controls (shocker) is not just a desperation move. It's short-sighted. In H2 2020, for instance, Russia entered a bilateral trade deficit with China as oil prices crashed. Should they crash down to the $60-75 range again while Chinese firms can quote markups for all exports to the Russian market, that's a serious risk. Suddenly the country Russian firms are depending on for liquidity to back trade has a surplus as leverage while also being able to import every commodity from elsewhere. Until the Russian military leaves Ukrainian territory or a revolution in economic thought strikes the regime, it can do little more on this front than bang a tin cup against the jailhouse door of the US dollar prison its commodity-dependent economy inhabits. I'll go more into the G7 price cap later this week.


  1. The Ministry of Construction is looking to stretch the underfunding of social needs further by allowing the Territorial Development Fund to launch projects across the regions using only federal money, allowing regional governments to sink their own revenues into them later. The relevant program is designed to replace unsafe, aging housing with new builds. From the reporting, it seems that the Presidential Administration and Putin want works accelerated, which means kicking more unfunded liabilities to the regions who, I'm guessing, they expect will be able to pay because the economy stabilizes faster than one should reasonably expect.
  2. S&P's services PMI returned to contraction (49.9) in August for the first time since June, suggesting that the consumption slowdown is starting to spread beyond goods most affected by restrictions on imports. There's more indirect pain coming in that regard since services are often clustered in cities. Apparently the production of railcars for metro systems fell 42% for January-July with not a single new car manufactured in July. That's going to affect commuters soon enough as breakdowns occur, disrupting getting to many retail and service jobs in urban cores.
  3. In yet another announcement challenging presumptions about Sino-Russian coordination, Huawei has reportedly moved a part of its workforce located in Russia to Kazakhstan, Uzbekistan, and elsewhere in the CIS. The company has identified those two markets as having the best outlooks across the region for growth and demand. This on top of ceasing orders from Russia for fear of secondary sanctions exposure.
  4. As of August 1, overdue consumer debts (excluding mortgages) exceeded 1 trillion rubles for the first time ever. Overdue generally means unpaid in 90 days. While January-July only saw an 8% y-o-y increase, the flipside of the problem is nominal. Inflation is high enough that this bit of news suggests not only pain paying off debts, but also that consumption is in serious trouble even as interest rates have settled at much lower levels than the initial Volcker-esque surge towards 20% for the key rate.

Like what you read? Pass it around to your friends! If anyone you know is a student or professor and is interested, hit me up at @ntrickett16 on Twitter or email me at nbtrickett@gmail.com. Always happy to look at any freelance opportunities pertaining to Russia, Eurasia, energy and commodities, or my old love foreign policy.

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